Question: Shirley has a rental house that she has owned and used in a rental activity for the last 10 years. Shirley now wants to give the property to her son, Joey. Will converting it to personal use be a taxable event, including recognition of depreciation recapture?
Answer: No. Because it is a gift rather than a sale, the transfer does not trigger recognition of unrecaptured §1250 gain. Shirley will, however, need to file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, to report the fair market value of the gift.
With a typical gift, including one formerly used in business, Joey would “step into the shoes” of his mom, and take her adjusted basis in the property.
In this way, a gift of business property doesn’t avoid the depreciation recapture rule; it merely shifts the burden to another taxpayer. Although the property does not get the §1014 step-up it would get upon Shirley’s death when it passed into her estate, the gift may still be worthwhile from a tax viewpoint. By gifting the property to Joey, who is in a lower tax bracket than Shirley, the after-tax return will still be higher if or when it is sold.
Therefore, when the property is sold, Joey will realize the same amount of ordinary income that Shirley would have realized had she retained the property and sold it.
The same rule applies (step into the shoes) if Shirley had gifted the property in trust, donated it to a charitable organization or transferred it in a part gift/part sale transaction, with some nuances in each case.
